Qualified Opportunity Zones, added as new Section 1400Z to the Tax Code by the Tax Cuts and Jobs Act, offer significant benefits to investors seeking to defer or abate their capital gains.
The zones, or “low-income communities” (as the term is defined in Section 45D of the code for New Markets Tax Credits) are designated by census tracts. The governors of each state designated up to 25 percent of such tracts in their state, and they could also choose up to 5 percent of tracts that are not low-income communities but are contiguous to low-income communities.
Although the proposal was slipped into the TCJA without much fanfare, interest in the provision has quickly grown.
“Interest in Qualified Opportunity Zones is off the charts,” said Dustin Stamper, managing director in the Washington national tax office of Top 6 Firm Grant Thornton. “Now that the proposed regulations are out, we have enough rules to start making investments.”
“Congress has put incentives in the code before to encourage investments in geographic areas, but this is the most generous tax incentive this type ever offered,” he said. “The tax benefits of QOZs are threefold: Taxpayers get to defer capital gain, then they get some of the deferred gain forgiven if they hold the investment for five to seven years, and then on top of that, if they hold it for 10 years, they recognize no additional gain at all from the investment.”
Investors generally have to pay tax on the deferred gain when they sell the investment, but mandatory gain has to be recognized at the end of 2026 even if they haven’t sold it, he explained: “So if they want the 15 percent forgiven for holding the investment for seven years, they have to make the investment before the end of 2019.”
Help for the downtrodden
“The Opportunity Zone Program was created to encourage those with long-term capital gains to invest in downtrodden neighborhoods, and it is one of the biggest things I’ve seen in my 37-year career,” said William Procida, founder and chief executive of Procida Funding. “Improving low-income, high-crime areas is and has been among the most important issues facing our country. This program will bring billions of dollars to these communities without the gigantic red tape of prior government-subsidized programs. The trick for investors will be how to actually implement these investments.”
“We were hoping that proposed guidance would say that if you get into 2020, you still have the opportunity for the benefits of a seven-year deferral, but you don’t — the deferral period lasts until Dec. 31, 2026,” said Paul Gevertzman, a tax partner at Top 100 Firm Anchin. “As you get closer to 2026, you lose some of the benefits.”
The proposed regulations, which came out on Oct. 19, 2018, are generally favorable to taxpayers, Stamper observed. “They allow either partners or the partnership itself to make the investment and defer gain,” he said. “In addition, the regs ruled that land will be qualified and doesn’t have to meet the original use requirement, because by nature land is permanent. There are a handful of important questions that these regs don’t address. These will be answered in the next round of proposed regulations, which will be issued shortly.”
“Left open is the question as to when the idea of original use can apply to a building that is vacant, abandoned or under-utilized. The preamble to the regs said the IRS is willing to make some accommodation, but we just don’t know how much until they come out with additional guidance,” he added. “Another question is how to treat the gain when a fund itself sells some of its assets. Most people are hoping that the gain wouldn’t be recognized if the fund reinvests in equal assets, but that’s not clear from the statute or the proposed regs.”
“These zones are everywhere — more than 8,700 zones have been designated,” he said. “Every major city has areas that qualify. It’s a huge opportunity.”
“Qualified Opportunity Zones have taken off like wildfire across the county,” agreed Jim Lang, a shareholder in the Tampa office of law firm Greenberg Traurig. “Interest has exploded nationwide. When the first round of proposed regs was released, that increased interest even more.”
The idea for Qualified Opportunity Zones grew out of a program sponsored by Senators Tim Scott, R-S.C., and Corey Booker, D-N.J. The investment can be supercharged by pairing it with credits such as the Affordable Housing and Low Income Housing Credits, and the New Market Tax Credit.
Qualified Opportunity Zones can be used for non-real estate investments, which is no longer the case with Section 1031 like-kind exchanges, noted Roger Harris, president of Padgett Business Services. “And unlike a Section 1031 exchange, you have the opportunity to pull money out,” he observed.
“Under the proposed regulations, a QOZ business may retain cash, cash items, and certain debt as reasonable working capital for up to 31 months without causing a failure of the 90 percent asset test,” said Jay Blaivas, a partner in the federal tax practice group of law firm Morrison Foerster. “They make it clear that a partner in a partnership may defer its share of qualifying capital gains of the partnership by reinvesting the gains in an OZ Fund. They also provide guidance on the methods to be used in calculating compliance with the 90 percent test, and they clarify that the requirement that ‘substantially all’ of a Qualified Opportunity Zone business’s tangible property consist of Qualified Opportunity Zone business property will be satisfied if 70 percent of its tangible property qualifies.”
A critical issue, which may be addressed in forthcoming guidance, regards the sale of Opportunity Zone fund interests, according to Blaivas. “A technical reading of the code provisions appears to require that in order to obtain the benefit of a fair-market value step-up after 10 years, the OZ fund interest must be sold — the OZ fund itself could not sell its OZ business property or OZ equity interests,” he said. “As a result, if a single owner wants to form an OZ fund, it would need to either form it as a corporation or, if it were formed as a partnership, the owner would also need to form a corporation to own an interest in the partnership in order for the OZ fund to be respected as a partnership for federal income tax purposes.”
By Roger Russell
Published December 03 2018, 9:01am EST
Roger Russell is senior editor for tax with Accounting Today, and a tax attorney and a legal and accounting journalist.